The Fiscal Commission And Conservative Tax Policy

[Published in Human Events 28 November 2010]

When asked about the Bush tax cuts, Milton Friedman, in characteristic piercing style, remarked, “I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible. … [T]he big problem is not taxes, the big problem is spending. … The only effective way I think to hold it down, is to hold down the amount of income the government has. The way to do that is to cut taxes.”

While many have preemptively dismissed the Fiscal Commission draft report, the influence of conservative members on the commission—Sen. Tom Coburn, Sen. Judd Gregg, and Rep. Paul Ryan—is evident on taxes, where, as Friedman suggested, things should begin.

Friedman is perhaps best known on fiscal policy for proposing that a single flat-rate tax on personal income replace all taxes, deductions, and loopholes. Disarming the government of tax manipulation as a tool to guide economic behavior would unleash the creative spirit that drives capitalism.

Coming tantalizingly close to Friedman, the Commission’s report recommends abolishing the alternative minimum tax (AMT), eliminating most exemptions and deductions, and consolidating personal tax rates into three lower brackets.

The report offers some useful purposes. First, it ventilates all that is wrong with our current tax system: a complexity that breeds uncertainty and that discourages entrepreneurship and investment. Details about exemptions and deductions should not obscure the fundamental principle that what is to one man a deduction is to another man a subsidy.

Second, it avoids, for the most part, the economic fallacy of tax progressivity—the liberal fantasy that to have graduated rates results in contributive fairness. Friedman demonstrated that graduated tax rates “… are much less a tax on being wealthy than on becoming wealthy … [because] they impede … the accumulation of wealth.”  [Capitalism & Freedom, 1962]

Third, the fiscal commission’s report launches a conversation about the disadvantageous misalignment of our corporate tax with those of the world’s advanced economies.  Their recommended reduction, while lacking boldness and clarity, is a tepid step in the right direction. 

What they miss, what most politicians miss, is that corporate taxes derive from the illusion that a corporation is a person, rather than what it truly is: a collection of people.  That the law treats it as a “juristic person” provides no economic justification for taxing its profits first at the corporate level and second at the stockholder level in the form of capital gains and dividends taxes.  

“Few measures,” Friedman said about abolishing double taxation of business, “would do more to invigorate capital markets, to stimulate enterprise, and to promote effective competition.”

After ending the corporate tax and attributing all business profits to the stockholder, Friedman calculated that the flat rate of 23½ % levied equally on all personal income, less standard exemptions and allowable deductions, would produce the same tax revenue as that resulting from the unintelligible labyrinth in the then extant tax code.

Present numbers yield the equivalent result.  In 2009, IRS collected $1.9 trillion net from all tax sources (IRS Data Book).  Applying 23½ % to the previous year’s aggregate adjusted gross income (AGI), $8.2 trillion, produces precisely $1.9 trillion. The flat tax raises the same amount as all individual, corporate, estate, AMT, and excise taxes combined.

And because AGI includes deductions for health-savings accounts, IRAs, Keoghs and 401(k) accounts, we could preserve such savings vehicles.

The closest we have come to the flat tax was during the second phase of President Reagan’s cuts in 1986, when only two brackets, 15% and 28%, remained.   This system followed the 1981 Kemp-Roth bill that lowered all marginal rates.  

The two cuts, or combined flattening, worked so well that the economy grew 30% in the eight years of Reagan’s presidency, unemployment fell from a peak of 10% to 5%, government revenue doubled, and—what will be difficult for liberals to swallow—the burden of taxation shifted more to the wealthy, according to a 1996 study by The Joint Economic Committee of Congress.    

Friedman observed the graduated tax is but “a clear case of coercion to take from some in order to give to others and thus to conflict head-on with individual freedom.”  

His genius was always to see matters of freedom first in problems of economics: a principle that should guide consideration of any tax or fiscal proposal.

The coming property tax revolt

[published in Human Events 14 June 2010]

Buried in the entrails of the reconciliation bill (H.R. 4872) that resulted in the passage of healthcare reform, is this insidious provision: Net investment income defined as “gross income from interest, dividends, annuities, royalties, and rents … attributable to the disposition of property” will be assessed 3.8% “Unearned Income Medicare Contribution”.  

BusinessWeek estimates, “Overall tax rates on income from interest, annuities and royalties would rise to as much as 43.4%.” By taxing investment income, the new law launches an assault on capital formation and growth. It is also an ambitious reach by the federal government, beyond the current capital gains tax, into revenue sources heretofore reserved to the local communities: personal property.

Defenders of the tax will venture that it applies above the threshold income level of $250,000, therefore hits only the rich; but the fact remains that without indexing or other protections, the new tax may affect more Americans over time, just as Congress’ neglect will subject 30 million this year to the alternative minimum tax -- originally intended for only 155 taxpayers.

If an increasing number send a portion of the proceeds of the sale of their homes to Washington, the new Medicare “contribution” could be viewed as a broad property tax, and the seeds of conflict between local and the federal governments will have been sown.

But there may be an incipient constitutional problem with federal property taxes. The framers thought restraining the way Congress applies such “direct” taxes so important, they wrote twice about it: “Representatives and direct taxes shall be apportioned among the several states” (Article 1, Sec. 2), and “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.” (Article 1, Sec. 9).

In a series of cases beginning with Pollack v. Farmers’ Loan & Trust Co. (1895), the Supreme Court struggled to elucidate the framers’ original intent on taxes. Pollackestablished, “In the matter of taxation, the Constitution recognizes the two great classes of direct and indirect taxes, and lays down two rules by which their imposition must be governed, namely: The rule of apportionment as to direct taxes, and the rule of uniformity as to duties, imposts, and excises.” Pollack found that taxes on income derived from property, such as rents, are considered direct, hence subject to apportionment.

Ratification in 1913 of the 16th Amendment removed the apportionment requirement for income taxes: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” 

In several cases, the Supreme Court clarified that the amendment serves only to remove the apportionment requirement on income taxes, but that Congress’ “plenary” authority to tax issues not comes from the amendment, rather from the original Articles in the Constitution.  

While the Warren Court in 1955 defined gross income as "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion", there are limits to the reach of the amendment. As recently as 2006, the U.S. Court of Appeals in D.C. stated, “The 16th Amendment simply does not authorize the Congress to tax as ‘incomes’ every sort of revenue a taxpayer may receive.” (Murphy v. IRS)

Such consistent references to the Articles as the guiding principles, allowed the constitutional requirement to apportion property taxes to survive even as court decisions over time deviated from original intent in other respects. In Penn Mutual v. Commissioner of Internal Revenue (1960), the Third Circuit Court of Appeals reaffirmed, “Indeed, the requirement for apportionment is pretty strictly limited to taxes on real and personal property and capitation taxes.”

If a reasonable case can be made that the new Medicare tax is indeed a property tax, then apportionment rules must apply, and the opportunity will have been spawned to limit government’s ambitions.

Unintended consequences need not always be negative. It would be fortuitously ironic if the healthcare reconciliation bill and Congress’ “land grab” ignites a debate on original intent and the utility of the 16th Amendment.